Trading CEFs using discounts relative to sector

Summary:Closed-end funds are trading at historically large discountsto NAV.

Buying liquid assets at a large discount is an unambiguous value playeven if the NAV discount never shrinks.

However, there is a very strong tendency for unusually large NAVdiscounts to mean-revert, providing a boost to return.

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How can I be so confident that investing in CEFs with unusually large NAV discounts will be a winning strategy? Because I have thoroughly tested it. The graph below illustrates just one of the tests, as applied to the high-yield CEF universe. The blue line is the cumulativeresidualreturn (net of our proprietary four-factor risk model) of an equal-weighted portfolio (20% each) of the five high-yield CEFs with the largest NAV discounts. The portfolio is reselected monthly. Since 2002, the average residual return (net of risk effects such as equity market and interest rate betas) has been 8.0% per year. The orange line is the same thing but investing in the five with the smallest (or most negative) NAV discount. That annual return has been -13.6%. The green line is a long-short implementation of the strategy. Its return has been 20.6% per year. The results have been both strong and consistent.

Source: Graph created by author using data from FactSet

Most other closed-end fund groups show similar results from a strategy of investing in those with the largest discounts to NAV. Results can be improved further by comparing the current NAV discount to the historical average discount for that CEF, buying only those with an unusually large discount relative to that CEF's own history.